Toys 'R' Us: No Game Changer For Vornado Realty

The IRS has tightened up the REIT laws since the Seritage spin, making it impossible for a C-corporation to spin off real estate (into a REIT); however, Vornado could buyout its partners and move to create a Toys “R” Us REIT . Vornado could even call the name of the new REIT, Dividends “R” Us.

According to Debtwire, Toys “R” Us has hired restructuring lawyers at Kirkland & Ellis to help restructure $400 million in debt the company will have to repay in 2018. Among the possible contingency options, the retailer is allegedly considering bankruptcy.

The suggestion of bankruptcy has prompted ratings agency S&P Global to downgrade the company’s credit rating by one notch to “CCC+” from “B-” and warn of another possible downgrade.

Toys “R” Us said it is currently evaluating a range of alternatives to address its 2018 debt maturities, and according to Debtwire “at quarter-end, the consolidated borrower had $701 million of liquidity, comprising $301 million in cash–mostly held overseas–and $400 million of availability under committed lines. At Toys Delaware, the company had $35 million of cash and $176 million available in credit lines.”

The first tranche of 2018 debt securities comes due in May 2018, which gives Toys “R” Us less than a year to make a move, remembering that the business is highly seasonal and historically fourth quarter net income accounts for more than 80% of its fiscal year net income.

Toys “R” Us faces formidable competition from Amazon, which has become a leader in books, toys and diapers. Also, many frugal moms and dads are turning to Wal-Mart (WMT) and Target (TGT) for baby and kids merchandise.

As of January 2017, Toys “R” Us operated 1,691 stores and licensed an additional 257 stores located in 38 countries. The toy chain currently operates nearly 870 stores in the United States and nearly 70 locations in Canada.

On July 21, 2005 Toys “R” Us was acquired by an investment group led by entities advised or affiliated with Bain Capital Private Equity, L.P., Kohlberg Kravis Roberts & Co. L.P. and Vornado Realty Trust (VNO).

The three partners paid $6.6 billion in a highly leveraged transaction that was a typical private equity deal of the era, with the exception of the involvement of a public REIT. Doubts about Vornado’s involvement were expressed by some from the start.

Over the years Vornado was making frequent plays "outside its wheelhouse,” which is unusual for a REIT. In doing so, Vornado made debt and/or equity investments in numerous companies that the company did not control (or had sole control), including investments in Alexander's (ALX), Toys 'R' Us, J.C. Penney (JCP), LNR Property and other equity investments.

Most of the non-traditional deals didn’t paid off for Vornado, and eventually the company opted to pivot and focus on its bread & butter business, New York real estate. However, a few of Vornado’s bets' did paid off, notably Alexander’s has been a good play (ALX owns Bloomberg's corporate headquarters in New York City).

In September 2013 Vornado sold its remaining 13.4 million shares in J.C. Penney for $13 a share, ending a three-year investment in the struggling department store operator it had pushed to renew itself. Vornado owned 6.1% of shares, which it sold in a block trade to Citigroup.

Vornado's original tender was for 9.9% in Penney concurrently with activist investor William Ackman's Pershing Square Capital Management and both pushed the retailer to offer trendier merchandise and try to attract a younger shopper. Obviously that bet didn't payoff and that $250 million hit translated to a 40% loss in Vornado's original investment in Penney.

Also, in April 2013 Vornado reaped around $241 million as net proceeds from the sale of LNR Property LLC, a company in which Vornado owned a 26.2% stake. The deal that LNR Property penned was disclosed in January 2013 and saw Starwood Property Trust (STWD) and Starwood Capital Group acquiring LNR Property for $1.05 billion. Both deals--Penney and LNR--were initiated as a means for Vornado to focus on improving its core real estate business.

Then in January 2015 Vornado separated the shopping center business by completing a tax-free spinoff into Urban Edge Properties (UE), a portfolio of 79 properties, three malls, and a warehouse. As part of the spin-off, Vornado shareholders received 94.6% of the shares, and Vornado retained a 5.4% ownership interest in the form of 5,712,000 UE operating partnership units.

In July 2017 it spun off large pieces of its legacy business to focus exclusively on New York City and key "trophy assets." Vornado has broad exposure in many high-quality assets in New York City, including Fifth Avenue, Times Square, Madison Avenue and Penn Plaza. The goal for Vornado was to complete the loop, and make Vornado a simpler investment model, by distinguishing the company’s circle of competence as a pure play New York City investment alternative.

But wait, Vornado still holds a 32.5% interest in Toys “R” Us. In the 2016 annual report the company states, “We carry our Toys investment at zero. As a result, we no longer record our equity in Toys' income or loss. Because Toys is a retailer, its operations subject us to the risks of a retail company that are different than those presented by our other lines of business. The business of Toys is highly seasonal and substantially all of Toys net income is generated in its fourth quarter. It is possible that the value of Toys may increase and we could again resume recording our equity in Toys' income or loss, which would increase the seasonality and volatility of our reported earnings.”

That’s standard operating procedure for a publicly-traded company to disclose the risks, but perhaps there’s a silver lining.

Dividend “R” Us?

As of January 2017, Toys “R” Us leased 1,383 of its properties out of 1,691 stores, this means there are 308 stores that are on-balance-sheet.

If the struggling retailer does not have adequate cash flow and capital resources to service its upcoming debt obligations, the company could seek to monetize its real estate by liquidating assets. I’m not certain who would want to purchase stores currently occupied by Toys “R” Us, but there is clearly a REIT (named Vornado) with an invested stake.

However, I’m not convinced a REIT structure is the solution for the toy retailer, the rationalization of Toys “R” Us revamping its business model under new owners hardly got started before the onset of the Great Recession. During this time, electric games gained vs. traditional 'physical' toys which meant competition with Amazon. This pressure continues today and hopes of a revival of traditional toys might be a non-starter.

One thing is quite clear as it relates to Vornado, the company has seen considerable shareholder value erode because of euphoric deal making. Today there are around 150 Equity REITs that enjoy ‘pure-play’ characteristics, where management can offer the promise of 'adding value' through their experience/contacts. Hence, investors have plenty of investment options vs. diversified players.

David Harris, assistant portfolio manager with Uniplan Investment Counsel, explains,"Vornado wasn't the only REIT to stray away from its core competency at the top of the market but their rehabilitation as a more narrowly orientated business has been a fine response to shareholders wanting to see more focused investments."

The temptation to step outside of one’s circle of competence can be strong, but as Warren Buffet reminds us (1996 Letter to Shareholders), “What an investor needs is the ability to correctly evaluate selected businesses. Note that word “selected”: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.”